Managerial ability and bond rating changes

• Author: Li Sun,Joel Harper,Kristopher J. Kemper
• DOI: http://doi.org/10.1111/fmii.12123
• Published date: 01 December 2019
• Date: 01 December 2019

DOI: 10.1111/fmii.12123

ORIGINAL ARTICLE

Managerial ability and bond rating changes

Joel Harper1Kristopher J. Kemper2Li Sun3

1Department of Finance, Farmer School of

Business, Miami University, Oxford, OH

2Department of Finance and Insurance,Miller

College of Business, Ball State University,

Muncie, IN

3School of Accounting and Computer

Information Systems, Collins College of Business,

The University of Tulsa,Tulsa, OK

Correspondence

KristopherJ. Kemper, Department of Finance and

Insurance,Miller College of Business, Ball State

University,Muncie, IN 47306, USA.

Email:kjkemper@bsu.edu

Abstract

This study examines the relation between managerial ability and

bond credit rating changes. We attempt to add to the credit rating

agency literature by exploring the role managerial ability plays in

the initial bond rating assignments and in ratingc hanges.We predict

firms with more-able managers are more likely to have higher bond

ratings and to be more able to have a positive influence on rating

changes. We find a significant and positive relation between man-

agerial ability and change in credit ratings,suggesting that more-able

managers can take effectiveactions to improve their credit ratings.

KEYWORDS

bond credit rating, bond ratingchange, managerial ability

JEL CLASSIFICATION

G24, G30, G34, M49

1INTRODUCTION

Followingthe most recent financial crisis, we have seen a great deal of attention paid to financial institutions and credit

ratings agencies. Credit ratings agencies haveweathered several legal actions against them and had to answer formal

complaints filed by the Department of Justice due to ratings of bonds that were perceived to be inaccurate or slow

to adjust to reflect the current risk of bonds. Credit ratings agencies also were criticized following the Asian Finan-

cial Crisis in 1997 and the dot.com bubble in the early 2000s (Alp, 2013). The scrutiny of and suspicion of credit ratings

agenciesis once again rooted in questions about the accuracy of their ratings, mostly as they pertained to mortgage tied

securities in the most recent crisis. Provisionsin the Dodd-Frank Act, along with a new special unit of the Securities and

Exchange Commission, added oversight to credit ratings agencies with the hope of avoidinga repeat of past failures.

Despite past shortcomings, credit ratings agencies are thriving, partially because of the increased governmentalmoni-

toring. As such, bond ratings continue to playan important role in financial markets warranting further research on the

rating process.

Prior studies (e.g. Dichev & Piotroski, 2001) suggest that bond creditratings convey price-relevant information and

affect firms’ investment decisions. Graham and Harvey(2001) find the consideration of bond ratings to be the second

c

2019 New YorkUniversity Salomon Center and Wiley Periodicals, Inc.

Financial Markets,Inst. & Inst. 2019;28:381–401. wileyonlinelibrary.com/journal/fmii 381

382 HARPER ET AL.

most important factor in the decision to issue more debt. Any revision to a bond rating can signal a change in a firm’s

financial future. Thus, managers have incentives to take necessary actions to improvetheir bond ratings and a better

understanding of the rating process is important. Surprisingly,there is limited empirical evidence on the role manage-

rial ability plays in the bond rating process. One possible explanation is that managerial ability is difficult to measure

because it is multi-dimensional. A method to quantify managerial ability was developed byDemerjian, Lev, and McVay

(2012). It is based on the relative performance of a firm that cannot be attributed to industry factors or other observed

traits. The advantage of this measure is that it uses publicly available information and is available for a large sample

of firms. In addition, it has been shown to outperform existing managerial ability measures. This method provides the

opportunity to examine the relation between managerial ability and bond ratings, providing insight into the effect of

firm management on the process of rating firm bonds and changes of those ratings.1

When examining bond rating changes, it is important to first establish a relation between the variable of interest,

managerial ability in this case, and the initial bond rating since a study of rating changes must be measured from an

initial base case, typically the prior year (Jorion & Zhang, 2006). Once this relation is established, then changes in rat-

ings can be examined. We posit a significant positive relation between managerial abilityand a change in bond rating.

Using 4,326 firm-year observations (upgrades and downgrades in bond ratings)from 1989 to 2016, we find a positive

relation between managerial ability and bond rating changes, suggesting that firms with more-able managers tend to

receive upgrades in their firms’ bond ratings.This relation gives additional explanation to the factors that rating agen-

cies deem important. We further identify the timing in which bond ratings respond to changes in managerial ability,

showing that changes in managerial ability are followed by bond ratings changes in the following year.We also show

that rating agencies do not anticipate changes in managerial ability,only react to it, as we do not find evidence of con-

temporaneous changes in managerial ability and credit ratings.

This study makes several important contributions. First, our paper contributes to the bond credit rating studies

in finance literature by establishing a positive and significant relation between managerial ability and credit rating

changes. To our knowledge, this is the first study that performs a direct empirical test on the link between manage-

rial ability and bond rating changes, showing that managerial ability is positively related to a subsequent change in

bond rating. Our paper also examines the Credit Watch lists and the influence managerial ability can haveon rating

agency warnings related to Credit Watch lists. Hence, our study contributes to a more comprehensive understanding

of the impact of managerial ability on bond ratings. Second, our study contributes to the managerial ability literature,

which has recently received tremendous attention. Wejoin the debate on whether having high ability managers is ben-

eficial or disadvantageous to an organization. Our findings support the notion in prior research (Hambrick, 2007) that

more-able mangers play a critical role in a firm’s decision-making process. We find this leads to positive bond rating

outcomes. Therefore, our evidence highlights the importance of having capable managers. Third, our findings suggest

that rating agencies are influenced by managerial ability when making bond rating decisions, adding further clarity to

the bond rating process by highlighting the effects of an able managerial team. Hence, our empirical evidence should

interest rating agencies when theyevaluate firms as well as when they develop models to assess credit risk. Finally, our

study has practical implications to different stakeholders, especially investors. Forexample, information on manage-

rial ability can help investors make accuratepredictions about (subsequent) bond ratings. Our results may encourage

investors to investin firms with more capable managers.

The remainder of this paper is organized as follows. Section 2 reviews related studies and presents the hypothesis

development. Section 3 presents the research design, including the measurement of the dependent and primary inde-

pendent variables, and the empirical specification. Section 4 discusses the sample selection and descriptive statistics.

Section 5 presents the main results, which establishes the link between managerial ability and a change in credit rat-

ings, and Section 6 presents the results of additional analyses. Section 7 provides endogeneity tests while Section 8

concludes the paper.